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Headline: Clearing and settlement - Now the real work starts
Source: Euromoney
Date: June 2000
Author: Julian Marshall
With the euro and Y2K safely hurdled, the securities industry is sizing up straight through processing as the next obstacle to creating a more efficient global market. The unification of exchanges and clearing and settlement platforms, which should enable this to happen, remains stymied by political manoeuvring. But market forces, aided by technological advances are set to force change. While the front offices of investment managers have been eagerly seizing the distribution opportunities presented by the internet, their back offices have plenty of catching up to do. Those that rise to the challenge will pull ahead of the pack. Julian Marshall reports
Stephen Smit has a vision for how he would like to see securities traded in the future. The model which Smit, a managing director in Europe of State Street's proprietary custody system Global Link, puts forward is radical only in its simplicity. New technology, he says, should allow for a cross-border equity transaction to be completed in four clicks of a fund manager's mouse.
The process would run like this:
A portfolio manager sitting in his or her office develops an investment idea and decides to buy, say 100,000 shares in a given company.
Click one: inputs the order into the trade order management system and routes the instruction to the equity blotter within the system on the buy side trader's desk.
Click two: routes the equity trade to either the broker of their choice, the exchange floor, or an alternative trading venue (for example an electronic crossing network).
As information on that equity fill flows back electronically, the trade order management system strips out the foreign exchange trade required to settle the transaction.
Click three: routes the foreign exchange trade to the counterparty bank of choice and as information on the foreign exchange fill comes back...
Click four: posts the transaction to the client's portfolio accounting system and simultaneously generates the Swift message notifying the custodian of the transaction.
Smit is by no means alone in his view of the markets of tomorrow. "There is no doubt that straight through processing (STP) is the number one project," says Jos Schmitt, a partner with the Capital Markets Company. "It is well on the way. We haven't achieved it yet but today there is a strong awareness among fund managers, custodians, sub-custodians and brokers that it is fundamental to our business."
Schmitt says the arrival of STP, coupled with the greatly enhanced distribution that the internet provides investment houses, will be revolutionary.
"The output from the new systems is what will allow you to use the new distribution channels made available by the new technology and to bring about a quality of service and information which has never been achieved before," he says. "If you put STP together with the new distribution channels, then you have e-commerce."
Leo Smith, head of equity trading at Putnam Investments in Boston, is impatient for change. "We need a unified settlement cycle across Europe, that is the ultimate goal, the end game," he says. "We want to have everybody on the same platform playing by the same rules."
He is optimistic about the effect that e-commerce is having on pushing change. He predicts its arrival within six to 18 months. "It will happen sooner than people are saying because technology is changing things so fast."
Smith is keen to push for a common settlement cycle because he says it will help the whole market, not just individual businesses. "We have to get to that common platform and we will encourage whatever it takes to get there sooner rather than later because the greater efficiencies will lead to a better market environment," he says. "It will help the front end, execution and overall volume."
The effect that this sort of technological advance will have on the markets will be dramatic, says Smit. State Street is looking to develop the tools and the technology to connect its clients with other clients. "The role of sell side firms acting as principals in transactions probably only has a limited life at this point," he says.
"Ultimately our clients really just want to deal with each other. We see our role as being an intermediary to facilitate those transactions between our clients."
One of Smit's main competitors agrees. Tom Perna, senior executive vice president and head of global custody at Bank of New York, says: "Bank of New York and State Street have turned into information companies."
Unfortunately that simplicity is still some way off as the providers of the clearing and settlement functions of trading continue to think in old economy terms, despite what examples from very recent history can teach them.
Just 18 months ago, for example, bankers had become so exasperated with the inability of the Chicago Board of Trade and Chicago Mercantile Exchange to work out a common clearing and settlement platform that they broke off all contact for two months. "We just don't care what they do anymore," one banker told Euromoney at the time. "We're going to develop our way of doing this if they can't."
Sure enough, within six months, seven of the larger players banded together to form Brokertec, an interdealer broker platform to trade cash securities and futures contracts which would rely on a settlement system it would develop and oversee, on its terms, with or without the established exchanges or clearing houses.
In Europe it would appear that clearing houses Euroclear and Clearstream are making the same mistakes as the Chicago derivatives houses. "The amount of money that both Clearstream and Euroclear are purportedly spending on identical developments is a duplication of costs that the market cannot really afford," says Terry McCaughey, chief operating officer for Deutsche Bank's global securities services in Europe. He has a better view than many on the machinations between Euroclear and Clearstream, having been director of global sales and customer services at Clearstream Banking until recently. He does not mince his words.
"To have two companies competing in an environment where one could accommodate the market's requirements is a travesty," says McCaughey, who points out that there are possible solutions that could see both organizations take shares of business without competing directly. It could be divided into clearing and settlement business versus custody business, or retail versus wholesale or bonds versus equities, he suggests.
"There's a number of ways in which the splits could be made which would allow one or other to develop the capabilities in their respective markets," he says. "But to have both competing on all fronts is a waste of money and effort and I think it's going to result at some point in one of them being made redundant and I think it's a shame that we're having to pay for that."
He does also lay the blame for the lack of decision-making on the group's respective shareholders. Clearstream has 93 shareholders, while Euroclear has 72, 38 of which are common to both organizations. Of these, the 10 biggest players have the ability to make a decision, he says.
"It's up to the market to decide," says McCaughey. "At the moment it's up to the two individual companies and I don't think the will is within them to make change because by necessity we won't need to duplicate the management structures."
That essentially is the root of the problem, he says, adding: "It's up to the chairmen of Euroclear and Clearstream to decide what's appropriate for their shareholders and if those shareholders aren't directing them in one particular way or the other, that's the market's fault."
Others, such as Bank of New York's Perna are more optimistic that something will be worked out soon. "I have a lot of confidence in Euroclear and Clearstream and the coming together of a lot of the clearing and depository structures in Europe," he says. "I think it's going to happen in order for the capital markets in Europe to progress in the way that everybody wants them to."
The good news is that STP is the area which is demanding the whole industry's attention now that both the introduction of the euro and Y2K have passed.
Ensuring systems were ready for both those issues dominated everyone's thinking but with them now safely negotiated, there is nothing to stop the drive towards STP and unified settlement.
Phil Goffin, head of e-business at Scudder Threadneedle Investments, reinforces this view. "The activity is really all around STP," he says. "Over the next 12 to 18 months everyone's systems will be joined up together and it is the internet revolution which will force it through."
There is still much to be done, he warns, though, adding that the fund management industry as a whole has not moved as fast as it might have in embracing the new technology.
"A lot of fund management companies are being quite slow in developing their e-business capability," he says. "Very few fund managers have actually established a complete STP link."
However he is confident that developments are accelerating. "We're not far off from institutions adapting and updating their systems and those that don't manage to are not going to last," he says.
Those organisations which adjust most quickly to the new environment will have a huge competitive advantage. "They will pull away very quickly from those that don't," says Goffin. "If they find themselves being left behind they will not be able to operate in the mainstream. They may still have a market but it will only be as a boutique."
Les Aitkenhead, head of investment administration at Gartmore Investment Management, agrees that there is a lot of work ahead but the industry is now moving in the right direction.
"We have been concentrating on STP at Gartmore for some time and some good things are starting to come to fruition," he says.
The main aim is to enable the back office to handle ever increasing amounts of business. "We are looking to make the operational area as volume insensitive as we can," he says.
"For all fund managers, trading activity is increasing and volumes are increasing. With the nature of the clients we have, which now includes hedge funds which by nature trade more actively than your normal institutional portfolio, it's very important for us to be able to process a greater number of trades accurately, on time, with as few people as possible in the chain."
Aitkenhead says the accepted wisdom that use of technology should lead to greater efficiency and hence profitability, applies in this case as in any other.
Deutsche's McCaughey has sympathy for the investment management world which has yet to respond fully to the opportunities available.
"To a large extent the fund management community has probably been starved of developments over the last four or five years in their middle and back offices, not least because of the euro and Y2K which took up the development budgets of most companies," he says.
Another factor has been the fact that margins have been squeezed by the upsurge in passive management. "That happened at just the same time that back offices needed to become more efficient which demanded funds as well," says McCaughey.
At Bank of New York, Perna, agrees that it has not been easy for fund managers to find the best ways to adapt to new technology in the back office, partly because of the number of custodians they have to deal with, each of which is pushing its own proprietary system.
Bank of New York's Inform system, which it first introduced three years ago, is moving towards browser-based technology away from desktop workstations. The system offers the bank's clients a secure trade instruction vehicle where they can track a trade from end-to-end while also enabling real-time entry and access to updated broker and account information.
"Hopefully this is making things easier on the fund managers because if all the custodians use browser-based systems then it gets them away from the idea of having a dozen different machines in their back office," says Perna.
He adds that those custody banks which are not prepared or able to make the necessary investment to provide these systems are quickly falling by the wayside. The custody business has become ruthless at weeding out the uncommitted. Consolidation has seen several established names pull out in the last couple of years.
"The haves and have-nots are separating very quickly and we will see the gap widen," says Perna. "More people like Lloyds and RBS Trust will reassess whether they want to stay in the business."
State Street faces no such uncertainties. Its Global Link system is becoming increasingly accepted by fund managers, having been installed with more than 250 firms globally, including 12 of the world's largest 20 by funds under management.
"We now have T+1 looming on the horizon and I think that, more than anything else, has focused the fund management community on the benefits of electronic transacting and STP and finding those operational efficiencies," says State Street's Smit.
However Deutsche's McCaughey warns that it will take more than just developing the technology for the markets to change. The fund managers need to be encouraged to invest in it.
"It's a two-way thing," he says. "The fund manager needs to have the capability to talk in the language that he is receiving from these systems. We can have the most sophisticated systems but if 90% of the fund management community isn't able to communicate in them then it doesn't help us much."
Raising standards globally is crucial in order to phase out archaic practices. "There's still a lot of fund managers who want to communicate in fairly old technology, like sending faxed photocopies of deal slips," says McCaughey.
"Fortunately they're becoming fewer and farther between but there is still a lot of it around, particularly in cross-border markets."
With cross-border volumes continuing to surge -- they are doubling every three years, according to State Street figures -- that is a worrying thought.
Crowded picture
Fund managers may still be relying on traditional methods of doing business but they are ready to make the great leap forwards, providing the best way is mapped out. Unfortunately the picture is far from clear.
"What the fund management community is faced with is this desire to implement technological solutions but at the same time you have a vast majority of sell side players who have devoted all of their resources, time and investment capital into developing internet based applications and the buy side just isn't ready for it," says Smit.
This proliferation of new developments in the market is also blurring the picture to such an extent, it is difficult for fund managers to choose which systems to support.
They face a headache-inducing choice of alternative trading systems and more than 40 ECNs all jockeying for their trade. Inevitably some systems will emerge from the morass but the sifting process will require fund managers to put their support into systems which may not survive.
"There is a reluctance among fund managers to choose but they have to jump in and go with a platform," says Smit. "It may not emerge as the winning platform at the end but if that's what happens they will have to bite the bullet and change to another one."
Above all it is important to make some sort of move. "You can't just sit back and wait for the dominant technology to emerge because you could be waiting for a very long time," he says.
Putnam's Smith speaks for many fund managers when he surveys the labyrinthine ECN network. "It's very frustrating because there's no rules of engagement between the different venues," he says. "It's all right to have multiple venues where you can get the same stock traded but you have to have a set of standardised rules that everyone must adhere to and abide by."
Smith says the technology is available to make this possible but it is crucial to establish a level playing field, particularly as ECNs start to claim a greater share of the market.
"Volumes are rising in those platforms because when you're in Rome you do as the Romans do and we're going to go where we can access liquidity," he says. "But it's not efficient from a dealing standpoint to try to access liquidity in the same name in nine different ECNs and five different regional exchanges and a primary exchange and alternative trading systems and what have you."
Gartmore's Aitkenhead sums up the concerns of many fund managers who are starting to use ECNs but are adopting a wait-and-see attitude. "Crossing networks are beginning to impact us but it's still a pretty small percentage of our total business," he says. "The jury's still out on whether they're going to take off."
Aitkenhead compares this situation with the uncertainties over the attempts to create global straight through processing and to unify the European exchanges and settlement platforms.
The Global Straight Through Processing Association (GSTPA), with more than 100 members including investment managers, broker-dealers and custodians, is working on creating an infrastructure for cross border securities transactions while Thomson and the Depository Trust & Clearing Corporation, the US equity clearing house, are also working together to similar ends.
Despite hopes and confidence that developments are on track some fund managers like Aitkenhead retain some doubts about what will happen.
"With the GSTPA it's all good theory and the industry can see that it will bring benefits but how it will get there is still a bit unknown," he says.
Meanwhile the well-documented saga of the possible unification of Europe's exchanges grinds on. A merry-go-round of announcements about various alliances between one or other of the different bourses and clearing organizations shows that the urgency is growing to drive some sort of unification through.
To many market observers it seems a combination of nationalistic tendencies and an unwillingness among the heads of the various organizations to relinquish power are preventing what will happen eventually anyway. However the balance of power seems to be shifting towards the market players, with the aid of the internet.
"In a few years, European boundaries are going to get blurred," says Scudder Threadneedle's Goffin. "There will be no differentiation between foreign and domestic markets because the internet and consumer demand are pushing that."
Putnam's Smith agrees. "We don't want different settlement cycles, different clearing houses," he says. "It's not efficient, not the most economical way of doing things and the technology is there. You should be able to put aside your personal country-by-country issues and work towards getting a common platform."
Smith says that, once the exchanges have worked themselves out, a common clearing platform will follow swiftly: "The stock markets are evolving and so in order for that to succeed you have to have the back end working hand in hand with it. Then you will have STP."
Those market participants who do not express confidence in the new developments are playing a losing game, says Smith. "The people who aren't so optimistic have other motives for keeping a fragmented, inefficient market because their business models support that kind of environment," he says.
"We don't support that view because we want to see greater transparency and efficiencies in the market."
Goffin adds that personalities will not hold sway for much longer. "You're always going to get people with their own agendas but market forces are pushing this now rather than clearing houses," he says. "They're facing pressure and they will get on and do it."
Heat on the back office
So assuming that the exchanges, the settlement platforms and those pushing through STP can get their act together, the investment managers now have their work cut out to be in a position to take advantage of all the changes.To date fund managers have only explored the internet's possibilities as a distribution tool.
This concept is beginning to take off. Many houses are selling directly while also tapping into the possibly greater potential of fund supermarkets where a single site offers customers access to a range of funds from a number of different firms.
Scudder Threadneedle has just committed to such a vehicle, forming a new £20 million ($32 million) venture with M&G, Gartmore and Jupiter Asset Management.
The internet revolution is forcing these alliances to drive economies of scale, says Scudder's Goffin. "Who would ever have thought we would join forces with these firms?" he says. "They are expensive to develop but the global market is evolving and people have to keep up with it."
So while front offices are forging ahead, other parts of the investment management houses are lagging behind. "The concept of e-commerce is still applied in a very limited way in the entire back office world overall," says the Capital Market Company's Schmitt.
There is a feeling among some market players that the back offices will continue to remain in the shadow.
"Fund managers will put their money where they think it can make a difference: either in the investment management process itself, the people who make the decisions or the distribution process," says Bank of New York's Perna. "They don't really look at the middle and back office."
It is impossible for institutions to make the necessary investment across the front, middle and back offices, says Perna. "You can't put the money everywhere. We've recognised that but we have picked our spot in the market and that is where we are committing our investment."
Back offices are set to receive more attention and more resources as IT budgets get freed up following the euro and Y2K issues. However more likely is that investment managers will increasingly look to outsource back office responsibilities to third parties. Again this is a trend started in the US where firms like JP Morgan Investment Management are leading the way through deals with custodians. In JP Morgan's case it was Bank of New York.
There is a sound economic argument for this approach: leave the administration headache to the custodian and it frees the investment operation to concentrate on making good investment judgements. Also the costs involved in bringing existing systems up to date are too great for some organisations to consider.
"Many of the market participants have started to realise in an increasingly competitive world that it is difficult to develop all those new services, or to re-engineer existing systems says Capital Markets' Schmitt. "There is a clear trend towards outsourcing core processing, as long as it does not raise competition issues, to third parties."
Europe is set to follow the US, says Schmitt, as fund managers will have to resolve how to provide a quality service and adequate information to their clients.
Where they can make a difference, he argues, is no longer in back office processing but it in the added value they can provide and the new technology is making that more widely available.
Gartmore, which has already outsourced to Bank of New York, is still waiting to see dramatic cost savings from the move but has gone through the bedding-in process and should now be ready to reap the benefits.
Gartmore's Aitkenhead says, the decision was an obvious one for the business: "The value added part of a company like Gartmore is not really in the operations side, it is in the fund management business," he says. "So anything which helps efficiencies in the operational part of the process, we can benefit from."
Technological advances will also enable institutions to cut costs as the cost of trading, particularly cross border, comes down with the reduction in settlement times.
This will be vital as trading volumes rise. It will also enable investment managers to keep down human resources costs. In an increasingly competitive market, this will be vital to survival.
"Fund managers are under great pressure to reduce costs because clients are becoming more difficult about paying too much money," says Schmitt. "Meanwhile the growth in volumes is only going to increase in a tremendous way."
In this fast moving market, opportunities are there to be exploited by lean and agile new entrants who can hit the ground running with the latest systems. "They don't face any legacy problems so they immediately have STP solutions and they can provide a better service at a lower price," says Schmitt.
Established players do have some cards to play though. "The advantage for the established players is that they already have business producing liquidity while new entrants have to build their business," says Schmitt, who warns that this will not give them the upper hand for long.
"They have some advantage in having assets in hand but it will only last as long as clients will accept poor service," he says. "If they don't change they will face big problems and they will not survive."
The securities industry faces some significant changes in the next few months as the blueprint for the markets of the future starts to become reality - a global market operating through fully-linked and compatible exchanges, with a unified settlement and clearing structure and a standardized settlement time.
Certainly there is still much to be done before that happens but Capital Markets' Schmitt offers a word of warning to those businesses which feel they can take a breather after dealing with recent IT hassles. "If you sit back in your chair and tell yourself you did well with the euro and Y2K so now you are fine, within a couple of years you will be out of business."
With technology driving the pace of change ever faster, the vision of a trade being ordered executed and settled with four clicks of a mouse may be nearer than most investors would have envisaged even months ago.
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